economics presentation

4-1 Copyright 2005 McGraw-Hill Australia Pty Ltd PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser

Chapter 4Price and income elasticity

$ Price Quantity• demanded• supplied

$ Income


Lecture Plan

• Price elasticity of demand• Measuring price elasticity of demand• Income elasticity of demand• Price elasticity of supply• Measuring price elasticity of supply• Factors affecting elasticity of demand• Factors affecting elasticity of supply


Price Elasticity of Demand

• How responsive consumers are to a change in the price of a product

• Types:– Elastic demand– Inelastic demand– Unit elasticity– Perfectly elastic demand– Perfectly inelastic demand


1. Elastic Demand• Small price changes lead to large changes in the quantity demanded • E.g. a product with many substitutes• Consumer demand is relatively responsive to price changes


2. Inelastic Demand

• Consumers’ demand is relatively unresponsive to price changes (i.e. a large price change causes only a small change in quantity demanded)

– E.g. cigarettes, essentials


• A change in price causes an equal change in Qd • e.g. a 10% increase in P causes a 10% decrease in

Qd

3. Unit Elasticity (Ed = 1)


4. Perfectly Elastic Demand (Ed =

• A change in price causes quantity demanded to be non-existent

• This is one theoretical extreme


5. Perfectly Inelastic Demand (Ed = 0)

• A change in price causes no change in the quantity demanded

• E.g. drugs of addiction, essential medicines

• This is the other theoretical extreme


Measuring Elasticity of Demand

Two methods:• Total revenue method • Point method


Total revenue = the amount received by firms fromconsumers buying goods/services

= Price × Quantity TR = P × Q

1. Total revenue method


Example A

• A firm decides to reduce the price of its product from $10 to $8. Quantity demanded will increase from 30 to 40 units sold

• At P = $10, TR = 10 x 30 = $300At P = $8, TR = 8 x 40 = $320

• Due to the price decrease, TR has risen• DEMAND IS ELASTIC


Example B

• The firm decides to reduce price further from $8 to $6 (Qd at $6 is 50 units)

• At P = $8, TR = $320At P = $6, TR = 6 x 50 = $300

• TR has fallen, DEMAND IS INELASTICP

QD

10

8

6

30 40 50

A

BC


Summary of Total Revenue Method

• When TR moves in the opposite direction to a price change, demand is ELASTIC

• If TR remains the same when price changes then demand has UNITARY ELASTICITY

• When TR moves in the same direction as the price change then demand is INELASTIC


2. The Point Method

• The degree of elasticity can be measured by the elasticity coefficient, or Ed in this formula: Ed = percentage change in Qd

percentage change in priceNote:

% change in Qd = change in Qd × 100 original Qd 1

% change in price = change in price × 100 original price 1


Interpretations

• Elastic demand: a given % change in price results in a larger % change in Qd

• E.g. 2% decline in price results in a 4% increase in Qd

Ed = 4/2 = 2• Where demand is elastic, Ed > 1• Note: it is conventional to ignore the minus sign

(cont.)


Interpretations (cont.)

• Inelastic demand: a % change in price is accompanied by a relatively smaller change in Qd

• E.g. 3% decline in price leads to a 1% increase in Qd

Ed = 1/3• Where demand is inelastic, Ed < 1• Unitary elasticity Ed = 1


Income Elasticity of Demand

• Measures responsiveness of the demand for a product due to changes in income

• Cross elasticity of demand: measures how the Qd of one good responds to changes in the price of another good


Price Elasticity of Supply

• The responsiveness of producers to changes in the price of a product i.e. ‘how much more’ will be supplied in response to a price rise?

• Measuring elasticity of supplyEs = % change in Qs

% change in price


Factors affecting elasticity of demand

• Availability of substitutes• Necessity• Habit and desirability• Proportion of income• Complementary products• Time


Factors affecting elasticity of supply

• Time• Ability to hold stocks• Excess capacity• Business expectations

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